Background

On September 4, the EU Commission published a proposal on a
Regulation for Money Market Funds (MMF) and a communication
outlining its wider shadow banking work.

This briefing note provides a short industry context, followed
by a summary of the Commission's key proposals.

The MMF Regulation is intended to address the risk that investor
"runs" could affect the stability of the sponsor, the
wider financial sector and ultimately the real economy. It is also
intended to protect investors by reducing the potential
disadvantages for late redeemers, particularly in stressed market
conditions. The proposal will have a significant impact on MMFs, as
well as their investors and those who use MMFs for funding
purposes. As near final drafts of the document were widely
circulated before their official release, the content is largely
expected. However, the Commission has softened its stance in
relation to exposure to securitisation and collateral. There are
three important elements of the proposal. First, the Regulation
proposes the introduction of a 3% cash buffer for Constant Net
Asset Value (CNAV) MMFs. This will reduce the profitability of
these types of funds and push up fees for investors. Second, the
Regulation proposes rules on what MMFs can invest in and what
activities they can perform, restricting the type of collateral
that can be used in reverse repurchase (repo) agreements and
banning MMFs from engaging in certain securities financing
transactions (SFTs). Third, there are proposed rules on risk
management, valuation and transparency. Notably, neither MMFs nor
their managers will be permitted to request ratings from credit
rating agencies.

The Commission's communication provides a 'roadmap'
for its shadow banking work. Much of the work relates to
transparency and data collection, with the Commission calling for a
regular quantitative monitoring exercise and highlighting the
transparency benefits of existing initiatives. In this respect the
Commission is supportive of the Legal Entity Identifier (LEI), and
will consider the possibility of transposing the LEI into EU law.
Other notable items include a possible extension of scope for
prudential banking regulation to a broader range of institutions, a
delay of proposals for non-bank resolution until 2014, as well as a
further delay to the long-awaited proposals on securities law to
2014.

Industry context

According to the European Systemic Risk Board (ESRB), EU MMFs
manage around €1 trillion in assets, of which over 40% are
accounted for by CNAV funds. The industry is heavily concentrated
in France, Ireland and Luxembourg, with CNAV funds split between
Ireland and Luxembourg at two-thirds and one-third of the total,
respectively. Due to their high liquidity and relatively stable
value, MMFs attract both retail and institutional investors, and
are often used as an efficient way to achieve diversified cash
management. They also provide an important source of short-term
funding for financial institutions, corporates and governments.
According to the Commission, MMFs hold 38% of short-term debt
issued by the banking sector. Due to their "systemic
interconnectedness" with the banking sector and wider economy,
MMFs have increasingly been in the regulatory spotlight. Reform of
the sector has been a priority under the umbrella of 'shadow
banking', which can broadly be defined as credit intermediation
taking place outside the regular (and regulated) banking
system.

Under the aegis of the G20, the Financial Stability Board (FSB)
has been pursuing a wide-ranging programme for reform of the shadow
banking sector, addressing the following five workstreams: (i) the
interaction of banks with non-banks; (ii) MMFs (including policy recommendations by the International
Organization of Securities Commissions (IOSCO)); (iii)
'other' shadow banking entities, such as exchange traded
funds (ETFs) and credit hedge funds; (iv) securitisation; and (v)
SFTs such as repo agreements. Several substantial documents on this
work are expected to be endorsed this week by the G20 Leaders in St
Petersburg.

It is in this international context that the Commission has
proposed the Regulation on MMFs and a communication on the broader
shadow banking agenda in the EU, outlining work done to date and
further work to come. These follow on from a March 2012 Green Paper on shadow banking, a consultation
on a revision to the Undertakings for Collective Investment in
Transferable Securities Directive (UCITS VI) in July 2012 in which MMFs were
covered, as well as a set of recommendations issued by the ESRB in December
2012. The United States has also been developing proposals to
address MMFs for some time, and the SEC finally published its
proposals in June 2013. The SEC put forward two alternative
reforms, which may be adopted alone or in combination. One of these
would require all prime institutional MMFs to adopt floating NAV,
while the other would allow them to continue to use constant NAV,
but would require liquidity fees and redemption gates during stress
periods.

The proposed MMF Regulation is broadly in line with the IOSCO
principles. While the Commission states that ESRB recommendations
have been "largely reflected" in the proposed Regulation,
it has not taken forward the ESRB recommendation to ban CNAV MMFs
outright.

An overview of the MMF Regulation

The below table provides an overview of the MMF proposals.

Objectives

Address the risk that investor "runs" could affect
the stability of the sponsor, the wider financial sector, and
ultimately the real economy.

Protect investors by reducing the disadvantages for late
redeemers, especially with respect to redemptions in stressed
market conditions.

Who is affected?

MMFs established, managed or marketed in the EU, as well as
UCITS and Alternative Investment Funds (AIF) that have the
"characteristics" of MMFs, will need to comply with the
Regulation.

Investors in MMFs.

Firms that rely on MMFs for funding purposes.

Key proposals

Rules related to the scope of the Regulation and authorisation
of MMFs.

Requirements for CNAV MMFs, in particular the introduction of a
3% NAV buffer.

Valuation rules, in particular that MMFs should mark to market
wherever possible, with only CNAV MMFs permitted to use the
amortised cost method.

Transparency rules, including on disclosure to investors and
reporting to competent authorities.

Rules setting out when MMFs can receive external support.

What's next?

The proposal will now pass to the European Parliament and
Council for negotiation and adoption.

A look at the key MMF proposals

Scope

The proposed Regulation will apply to MMFs established, managed
or marketed in the EU. This includes UCITS and AIFs that that have
the "characteristics" of MMFs, such that they invest in
short term assets and have the objectives of offering returns in
line with money market rates and/or preserving the value of the
investment. The majority of MMFs in the EU operate under the UCITS
Directive and the remaining MMFs should be operating, as of July
2013, under the Alternative Investment Fund Managers Directive
(AIFMD). MMF Managers will continue to be regulated under either
UCITS or AIFMD, but will also need to comply with additional rules
under the MMF Regulation. Rules related to the authorisation of
MMFs are proposed, with UCITS or AIFs only allowed to use the MMF
designation, or imply they are MMFs, if they are authorised in
accordance with the MMF Regulation.

CNAV MMFs

The most significant requirements in the proposal relate to CNAV
MMFs. These are MMFs where the accounting methodology permits a
stable face value, such as at 1€, $ or £. CNAV MMFs will
be required to establish and maintain a "NAV buffer" of
at least 3% of the total value of their assets, with notification
to competent authorities and the European Securities and Markets
Authority (ESMA) if the buffer falls below this by a specified
amount. CNAV MMFs that fail to maintain the buffer must vary the
NAV and cease to be CNAV MMFs. According to the Commission's
Impact Assessment, "if all managers decide to build up a
buffer, the initial amount of the capital to be raised will amount
to around €14 billion in Europe". The NAV buffer can only
be used to cover differences between the CNAV MMF's constant
NAV per unit or share and its NAV per unit or share, or
"real" value. It must not be included in the calculation
of the NAV or constant NAV and must be held in cash in a separate
and protected reserve account opened with a credit institution
(which meets certain requirements). The intention is that an agreed
"entity", for example this could be the sponsor or MMF
manager (although the text does not specify), will establish and
replenish the buffer. However, questions remain about the mechanics
of how the buffer will work in practice.

In introducing the buffer, the Commission is seeking to address
the risk of CNAV MMFs coming under pressure and failing to maintain
a stable price, leading to investor runs. This so-called
"breaking the buck" occurred in the US in 2008 to the
Reserve Primary Fund following the collapse of Lehman Brothers and
sparked increased regulatory focus on the risks posed by these
types of funds. The introduction of the buffer is likely to
significantly impact the MMF market. Concerns exist that for a low
margin product like an MMF, the buffer will call into question the
economic viability of CNAV MMFs for some providers and lead to a
reduction in supply. While the Commission states that the buffer
will benefit investors by insulating them against losses, it will
also push the cost up to investors, with the Commission putting the
increase in management fees at between nine and 30 basis points
annually. Investors, including firms that use MMFs for cash
management purposes, will need to think carefully about where they
put their money in future.

Investment policies

The proposal sets out what MMFs can invest in, as well as
activities they cannot undertake. MMFs will only be permitted to
invest in money market instruments, deposits with credit
institutions, financial derivative instruments and reverse repo
agreements that meet certain requirements. In an apparent softening
of the Commission's approach, money market instruments that
take exposure to securitisation, for example Asset Backed
Commercial Paper, will be considered eligible investments provided
they meet certain requirements. In order for a reverse repo
agreement to be eligible for inclusion in the MMF's portfolio,
the MMF will need to have the right to terminate the agreement at
any time upon a notice of two working days. The assets received as
part of the agreement will need to be money market instruments
which meet certain requirements, such as on credit quality and
maturity. Again in an apparent softening of the Commission's
stance, certain high quality central authority or central bank debt
instruments will also be eligible as collateral for reverse repos.
MMFs would only be allowed to invest in financial derivative
instruments used for hedging interest rate and currency risk where
the underlying instruments are interest rates, exchange currencies
or indices representing these categories.

Under the proposals, MMFs will not be permitted to: short-sell
money market instruments; gain direct or indirect exposure to
equities or commodities; enter into securities lending, borrowing
or repo agreements; or borrow or lend cash. The proposal also sets
out rules related to portfolio diversification and concentration.
MMF managers will be required to have a documented "internal
assessment procedure" to assess the credit quality of money
market instruments that it intends to invest in. This should be
"prudent" and "rigorous", based on an internal
rating system and methodologies, meeting other requirements, and
subject to appropriate governance.

While the Commission has softened its stance on exposure to
securitisation and collateral, the restrictions are nevertheless
likely to push up demand for eligible assets at a time when there
are already a number of initiatives in train that will affect
demand for collateral.

Risk management, valuation and transparency

The risk management rules aim to ensure adequate liquidity for
MMFs. The Commission has stayed away from introducing specific
tools for the temporary suspension of redemptions, but notes that
the UCITS and AIFM Directives already have certain provisions
related to this. Instead, the Regulation proposes portfolio rules
for both "short-term" and "standard" MMFs,
setting out the maximum weighted average maturity (WAM) and
weighted average life (WAL) that their portfolios should have.
There are also requirements for the minimum amount of liquid assets
that MMFs should hold that mature daily or weekly. MMF managers
will need to comply with "know your customer" rules to
help them anticipate large redemptions. Rules for stress testing
are also proposed.

As part of a general regulatory trend seeking to reduce reliance
on external credit ratings, the MMF or MMF manager will not be able
to "solicit or finance" a credit rating agency to rate
the MMF under the proposals.

Rules related to the valuation of MMF assets are also proposed,
specifying that they should be valued at least on a daily basis and
by marking to market "whenever possible". When marking to
market is not possible or market data is not of sufficient quality,
marking to model can be used. CNAV MMFs may also use the amortised
cost method.

Transparency proposals include that MMFs must clearly disclose
whether they are "short-term", "standard" or
"CNAV" in their communications and in no way suggest that
the investment is guaranteed. There are additional disclosure
requirements for CNAV MMFs in relation to the "NAV
buffer". The Regulation also introduces requirements for
reporting to competent authorities.

External support from third parties

The proposals seek to reduce the uncertainty of the
discretionary nature of external support, which the Commission
believes makes MMFs "even more vulnerable to runs during
periods of financial instability". CNAV MMFs will only be able
to receive external support through the NAV buffer. Other MMFs will
not be allowed to receive external support, except in certain
exceptional circumstances permitted by the competent authority
which are "justified by systemic implications or adverse
market conditions".

Communication on shadow banking

The Commission's communication provides a 'roadmap'
for the coming months on its shadow banking work. In large part,
the Commission will look to achieve its aims through existing or
expected legislation, with targeted supplemental work where the
Commission believes it is needed. The multifarious initiatives
referenced by the Commission are an indication of how tricky a
problem 'shadow banking' is to address. Moreover, although
there are prudential elements to the shadow banking agenda, much of
the work relates to transparency and data collection, highlighting
the continuing difficulties in simply understanding the financial
relationships which constitute the marketplace.

Key points from the communication include the following:

On the LEI, the Commission says it "will consider the
possibility" of a law to transpose the LEI into the EU legal
framework.

During implementation of the European Market Infrastructure
Regulation (EMIR) and future reviews the Commission will
"assess the coverage" of entities involved in shadow
banking, and will decide whether "supplementary
initiatives" are needed.

The expected legislative proposal on securities law has been
pushed back further to 2014, but the Commission is "closely
following" the work of the European Central Bank (ECB) to
collect real time data on repo transactions.

Within asset management, there will be a "global
assessment of the framework in which certain funds can
operate", including how they use securities financing
transactions.

The Commission is "thinking about" extending the
scope of prudential banking rules. There will be a "precise
assessment" of the application of the definition of
'credit institution' within the EU member states, with the
Commission ready to "clarify" the definition if it deems
necessary.

The forthcoming proposal on non-bank resolution will be limited
to Central Counterparties (CCPs), with a communication to be issued
on the "policy orientation" for other non-banks, though
this work has been pushed back to 2014.

Finally, on data, the Commission calls for a regular
quantitative assessment of shadow banking, to take place "at
least annually".

What's next?

The Commission's MMF proposal will now pass to the European
Parliament and to the Council for negotiation and adoption. Timing
will be affected by the competing priorities of other initiatives
and the potential disruption to proceedings resulting from next
year's European Parliament elections and the end of term of the
current College of Commissioners. Once the Regulation enters into
force, existing MMFs, as well as UCITS or AIFs that share similar
characteristics and therefore fall in scope of the Regulation, will
have only six months to submit an application to their competition
authorities together with all documents and evidence required to
demonstrate compliance with the Regulation. CNAV MMFs will have
three years to build up their NAV buffer. As a Regulation, the
rules will be directly applicable across EU Member States.

Substantial work to address shadow banking remains, both
internationally through the FSB and at the European level. There is
clearly a strong regulatory will to push reforms through, but some
of the proposals are likely to prove controversial with industry,
not least of which is yesterday's proposed Regulation for MMFs,
against which there is likely to be a concerted lobbying effort.
The Commission has not committed to firm deadlines for further
proposals to address non-MMF shadow banking issues, noting simply
that other measures will follow "as soon as possible."
However, with shadow banking to be discussed further at the G20
this week, many industry sectors will need to keep watching this
agenda.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

In our report "The next frontier - the future of automated financial advice in the UK", published in April, we noted that a key regulatory challenge for firms in providing automated advice is understanding...

In the first half of 2018, two major new pieces of regulation will "go live" as the revised Payment Services Directive and the General Data Protection Regulation come into effect from January and May respectively.

This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).

Email Address

Company Name

Password

Confirm Password

Position

Mondaq Topics -- Select your Interests

Accounting

Anti-trust

Commercial

Compliance

Consumer

Criminal

Employment

Energy

Environment

Family

Finance

Government

Healthcare

Immigration

Insolvency

Insurance

International

IP

Law Performance

Law Practice

Litigation

Media & IT

Privacy

Real Estate

Strategy

Tax

Technology

Transport

Wealth Mgt

Regions

Africa

Asia

Asia Pacific

Australasia

Canada

Caribbean

Europe

European Union

Latin America

Middle East

U.K.

United States

Worldwide Updates

Check to state you have read and agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you
are granted a non-exclusive, revocable license to access the Website under its
terms and conditions of use. Your use of the Website constitutes your agreement
to the following terms and conditions of use. Mondaq Ltd may terminate your use
of the Website if you are in breach of these terms and conditions or if Mondaq
Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to
read the full text of the content and articles available (the Content). You may
not modify, publish, transmit, transfer or sell, reproduce, create derivative
works from, distribute, perform, link, display, or in any way exploit any of the
Content, in whole or in part, except as expressly permitted in these terms &
conditions or with the prior written consent of Mondaq Ltd. You may not use
electronic or other means to extract details or information about Mondaq.com’s
content, users or contributors in order to offer them any services or products
which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the
suitability of the information contained in the documents and related graphics
published on this server for any purpose. All such documents and related
graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or
its respective suppliers hereby disclaim all warranties and conditions with
regard to this information, including all implied warranties and conditions of
merchantability, fitness for a particular purpose, title and non-infringement.
In no event shall Mondaq Ltd and/or its respective suppliers be liable for any
special, indirect or consequential damages or any damages whatsoever resulting
from loss of use, data or profits, whether in an action of contract, negligence
or other tortious action, arising out of or in connection with the use or
performance of information available from this server.

The documents and related graphics published on this server could include
technical inaccuracies or typographical errors. Changes are periodically added
to the information herein. Mondaq Ltd and/or its respective suppliers may make
improvements and/or changes in the product(s) and/or the program(s) described
herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally
identifies you, including what sort of information you are interested in, for
three primary purposes:

To allow you to personalize the Mondaq websites you are visiting.

To enable features such as password reminder, newsletter alerts, email a
colleague, and linking from Mondaq (and its affiliate sites) to your website.

Mondaq (and its affiliate sites) do not sell or provide your details to third
parties other than information providers. The reason we provide our information
providers with this information is so that they can measure the response their
articles are receiving and provide you with information about their products and
services.

If you do not want us to provide your name and email address you may opt out
by clicking here .

If you do not wish to receive any future announcements of products and
services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to
view the free information on the site. We also collect information from our
users at several different points on the websites: this is so that we can
customise the sites according to individual usage, provide 'session-aware'
functionality, and ensure that content is acquired and developed appropriately.
This gives us an overall picture of our user profiles, which in turn shows to
our Editorial Contributors the type of person they are reaching by posting
articles on Mondaq (and its affiliate sites) – meaning more free content for
registered users.

We are only able to provide the material on the Mondaq (and its affiliate
sites) site free to site visitors because we can pass on information about the
pages that users are viewing and the personal information users provide to us
(e.g. email addresses) to reputable contributing firms such as law firms who
author those pages. We do not sell or rent information to anyone else other than
the authors of those pages, who may change from time to time. Should you wish us
not to disclose your details to any of these parties, please tick the box above
or tick the box marked "Opt out of Registration Information Disclosure" on the
Your Profile page. We and our author organisations may only contact you via
email or other means if you allow us to do so. Users can opt out of contact when
they register on the site, or send an email to unsubscribe@mondaq.com with “no
disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate
registration form. This is a personalised service where users choose regions and
topics of interest and we send it only to those users who have requested it.
Users can stop receiving these Alerts by going to the Mondaq News Alerts page
and deselecting all interest areas. In the same way users can amend their
personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an
identifying user number. The cookies do not contain any personal information
about users. We use the cookie so users do not have to log in every time they
use the service and the cookie will automatically expire if you do not visit the
Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to
personalise a user's experience of the site (for example to show information
specific to a user's region). As the Mondaq sites are fully personalised and
cookies are essential to its core technology the site will function
unpredictably with browsers that do not support cookies - or where cookies are
disabled (in these circumstances we advise you to attempt to locate the
information you require elsewhere on the web). However if you are concerned
about the presence of a Mondaq cookie on your machine you can also choose to
expire the cookie immediately (remove it) by selecting the 'Log Off' menu option
as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example,
advertisers). However, we have no access to or control over these cookies and we
are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement,
and gather broad demographic information for aggregate use. IP addresses are not
linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or
its affiliate sites) are not responsible for the privacy practices of such other
sites. We encourage our users to be aware when they leave our site and to read
the privacy statements of these third party sites. This privacy statement
applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or
contests. Participation in these surveys or contests is completely voluntary and
the user therefore has a choice whether or not to disclose any information
requested. Information requested may include contact information (such as name
and delivery address), and demographic information (such as postcode, age
level). Contact information will be used to notify the winners and award prizes.
Survey information will be used for purposes of monitoring or improving the
functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our
site, we ask them for the friend’s name and email address. Mondaq stores this
information and may contact the friend to invite them to register with Mondaq,
but they will not be contacted more than once. The friend may contact Mondaq to
request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’
information. When users submit sensitive information via the website, your
information is protected using firewalls and other security technology. If you
have any questions about the security at our website, you can send an email to
webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode),
or if a user no longer desires our service, we will endeavour to provide a way
to correct, update or remove that user’s personal data provided to us. This can
usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will
post those changes on our site so our users are always aware of what information
we collect, how we use it, and under what circumstances, if any, we disclose it.
If at any point we decide to use personally identifiable information in a manner
different from that stated at the time it was collected, we will notify users by
way of an email. Users will have a choice as to whether or not we use their
information in this different manner. We will use information in accordance with
the privacy policy under which the information was collected.

How to contact Mondaq

If for some reason you believe Mondaq Ltd. has not adhered to these
principles, please notify us by e-mail at problems@mondaq.com and we will use
commercially reasonable efforts to determine and correct the problem promptly.